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1 SHOULD WE BALANCE THE FEDERAL BUDGET? (7 of 7)

1 SHOULD WE BALANCE THE FEDERAL BUDGET? (7 of 7)

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APPLICATION 1



CREATING THE U.S. FEDERAL FISCAL SYSTEM THROUGH DEBT POLICY



APPLYING THE CONCEPTS #1: Why did the early U.S. federal government take over the debts of the thirteen colonies?



When the United States enacted its new Constitution in 1789, it replaced the Continental Congress and centralized power in the federal government. The federal
government became the sole power to be able to raise revenue through tariffs on imported goods, but also assumed the debts of the state governments. Alexander
Hamilton, who conceived and promoted this new arrangement, saw it as a way to strengthen the federal government so that it could borrow externally as needed
for wars or other needs. The states were willing to give the tariff power to the federal government in exchange being absolved of their debts.



Nobel Laureate Thomas J. Sargent noted, however, that when the states again got into fiscal difficulties in the 1840s through overly ambitious infrastructure
investment, the federal government did not bail out the states. This time, the federal government did not want to enhance its power and control over the states,
which were forced to impose new rules and fiscal discipline on themselves to avoid future fiscal disruptions. Together, these two episodes helped define the fiscal
structure of the United States: a strong central government and independent but fiscally responsible states.

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17.2 SHOULD THE FED TARGET BOTH INFLATION AND
UNEMPLOYMENT? (1 of 2)

Two Debates About Inflation Targeting
DEBATE 1: SHOULD THE FED FOCUS ON ONLY INFLATION?

We have learned that in the long run, monetary policy can influence only the level of prices, not the level of employment. Proponents of inflation targeting argue that the Fed
should have only one primary goal: controlling inflation.

Before he took over as chairman of the Federal Reserve in 2006, Ben Bernanke was an advocate for inflation targeting. Bernanke called inflation targeting a policy of
constrained discretion. Under inflation targeting, the Fed could take actions to offset shocks to real output or to the financial system, but it had to keep its long-run inflation
targets in clear view.

However, many economists disagree with the idea of inflation targeting because they strongly object to the Fed concentrating solely on controlling inflation.

Economists also debate the level for an inflation target. It is very difficult to measure changes in prices accurately when there is a great deal of technological change
occurring in the economy.

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17.2 SHOULD THE FED TARGET BOTH INFLATION AND
UNEMPLOYMENT? (2 of 2)

Two Debates About Inflation Targeting
DEBATE 2: IF THERE WERE AN INFLATION TARGET, WHO WOULD SET IT?

In the United Kingdom, which adopted targeting in 1992, the elected government decides on the inflation target for the central bank.

In other countries, the central bank has more influence in setting the inflation target.

Under current law, the Fed chairman reports regularly to Congress, but the Fed has considerable power to use monetary policy to stabilize output as well as to fight inflation
as it pleases.

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APPLICATION 2



WOULD A POLICY RULE HAVE PREVENTED THE HOUSING BOOM?



APPLYING THE CONCEPTS #2: Did the Federal Reserve cause the housing boom through excessively loose monetary policy?



John Taylor of Stanford argued that the Fed’s “easy money” policy from mid-2001 through 2004 was responsible for the housing boom.



The Fed lowered interest rates from 2 percent in 2001 to 1 percent in 2004. Using the Taylor Principle, he found they should have raised it to 4 percent.



He showed that housing starts, which are very sensitive to interest rates would have been much lower and the boom and bust would have been avoided.

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17.3 SHOULD WE TAX CONSUMPTION RATHER THAN INCOME? (1 of 3)


Consumption taxes
Taxes based on the consumption, not the income, of individuals.

Two Debates About Consumption Taxation
DEBATE 1: WILL CONSUMPTION TAXES LEAD TO MORE SAVINGS?

There is no question that taxing consumption instead of savings creates an incentive to save. However, there’s no guarantee the incentive will actually result in more
money saved in the economy.

People will want to take advantage of this incentive and reduce consumption and increase savings. On the other hand, people will also want to spend more because,
with the tax cut, they are wealthier.

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17.3 SHOULD WE TAX CONSUMPTION RATHER THAN INCOME? (2 of 3)

Two Debates About Consumption Taxation
DEBATE 2: ARE CONSUMPTION TAXES FAIR?



Capital gains
Profits investors earn when they sell stocks, bonds, real estate, or other assets.

In practice, moving to a consumption-tax system could have a major impact on the distribution of income in the economy.

Suppose we simply exempted the returns from savings from the income tax.

This exception would clearly favor wealthy and high-income individuals who save the most and earn a lot of income in interest, dividends, rents, and capital gains.

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